Were HSBC Preferred Stock Shareholders Cheated?

The U.S. Federal Deposit Insurance Corporation, or FDIC, has become the first investigating body to name HSBC, the UK's largest bank by both market capitalization and assets, and with 15 other banks in the two-year LIBOR rate manipulation probe. If the March 14, 2014 charges stick, HSBC will join several other international banks which had been issuing new variable-rate preferred stocks while they were manipulating the rate that those half-billion shares paid to shareholders.

Apr 2, 2014 at 7:00AM

On March 14, 2014, banking investigators at the U.S. Federal Deposit Insurance Corporation, or FDIC, charged 16 banks with manipulating the London Inter-Bank Offered Rate, or LIBOR. International investigators had previously issued $3.7 billion in fines in the two-year scandal, naming Barclays, the Royal Bank of Scotland, Dutch lender Rabobank (fined $1 billion last fall) and UBS.

The LIBOR is the rate European banks charge each other for overnight cash loans, much like the federal funds rate in the US. Observers see the LIBOR rate that a bank pays as a statement about the bank's stability: The stronger the bank, the lower the rate it has to pay for such cash.

As international banking investigators have now exposed, several of those charged with reporting the rates that determined the LIBOR have been allegedly fudging the rate downward since 2005, which made their banks look stronger than they really are (and pushed the LIBOR lower than it should have been).

Half-billion preferred stock shares underpaid
About a half-billion shares of variable-rate preferred stocks are included in the trillions of dollars' worth of financial contracts, mortgages and securities which have their rates set via LIBOR-based formulas. The extent to which shareholders were shorted is not yet known, but we do know that of the variable-rate LIBOR-based preferred stocks issued since January 2005, the 23 listed on this table are still trading and they would have been affected.

Source: CDx3 Notification Service database, www.PreferredStockInvesting.com.

While prior investigations have found the LIBOR rate has been manipulated by these banks since early 2005, last month's FDIC charges claim the collusion continued through at least mid-2011.

Manipulation period: January 2005 through October 2008
Of the four methods used to set dividend rates for variable-rate preferred stocks, the LIBOR-based method is the most common. Typically, these securities pay dividends which are calculated by adding a certain percentage to the then-current three-month LIBOR, unless that falls below a certain minimum rate.

That means since October 2008, when the LIBOR fell to new lows, the LIBOR manipulation that had been going on since January 2005 became irrelevant to preferred stock shareholders since the minimum rate kicked in for dividend payments.

However, between January 2005 and October 2008, the LIBOR ranged from about 2.5 percent to about 5.5 percent, high enough that it was being used to calculate (erroneously) the dividends which were paid on the variable-rate preferred stocks itemized in the above table.

HSBC: captain of the home team?
The UK's HSBC Holdings plc (NYSE:HSBC), which many would consider the captain of the home team when it comes to the LIBOR, is the UK's largest bank by both market capitalization and total assets. Last month's FDIC charges were the first to implicate HSBC in the LIBOR scandal.

As startling as these charges are, it gets a lot worse when you consider what else was going on at the time with HSBC.

In late-2012, HSBC was fined $1.92 billion for laundering cash on a massive scale over a period of years for the world's drug cartels. If the FDIC has it right with its current charges, at the same time when HSBC personnel were cleaning the dirty drug cash, others within the organization were down the hall manipulating the LIBOR.

HUSI-F and HUSI-G
HSBC has two variable-rate preferreds trading that pay dividends based on the LIBOR rate: HUSI-F (originally issued as HBA-F), issued on April 1, 2005 and HUSI-G (originally issued as HBA-G), issued six months later on October 11, 2005, both of which pay dividends quarterly.

The prospectus for HUSI-F says the dividend rate will be calculated by adding 0.75 percent to the three-month LIBOR published at the time, with a minimum rate of 3.50 percent. That means that as long as the LIBOR is above 2.75 percent, shareholders will receive a quarterly dividend calculated by adding 0.75 percent to the LIBOR.

HUSI-F and HUSI-G were issued with 18 million and 13 million shares, respectively, and they paid a total of 24 dividends during the manipulation period which were worth about $130 million to preferred stock investors.

Redefining dishonorable conduct
The FDIC's charges, if proven, mean officials at HSBC issued 31 million shares of new variable-rate preferred stocks in 2005 which used a dividend formula that they themselves were manipulating.

While each of the banks may have involved behaved dishonestly (at best), by adding HSBC to the list last month, the FDIC has moved this UK bank into a category that could be well beyond dishonorable, given its prior relationship to the world's drug cartels. Any claim by the bank that the money laundering was just a slip-up by a few rogue employees becomes substantially harder to accept when considered in the light of the FDIC's new charges.

If you held shares of any of the 23 variable-rate preferred stocks listed above between January 2005 and October 2008 you were almost certainly paid dividends that were short of what was due.

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Doug K. Le Du is the author of Preferred Stock Investing, Fifth Edition and owner of the CDx3 Notification Service database that was used for this article. He has no position in any stocks mentioned.The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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